If there's easily recognizable value somewhere, anywhere, in
your business, you can generally get a loan against it to help fund
the growth of your company.

This is the fundamental idea behind so-called asset-based
loans--a potent source of funding for established small businesses,
according to William Barnett, an attorney with the law firm
Herrick, Feinstein LLP in New York City who specializes in
asset-based lending. Specifically, he says, "Asset-based
lending is formula lending based on the liquidation value of
accounts receivable and inventory."

David R. Evanson's newest book about raising capital is
called Where to Go When the Bank Says No: Alternatives for
Financing Your Business (Bloomberg Press). Call (800) 233-4830
for ordering information. Art Beroff, a principal of Beroff
Associates in Howard Beach, New York, helps companies raise capital
and go public.

A Framework For Lending

While lenders making term loans (loans that are paid back over a
span of two to five years) certainly consider the value of these
assets, value is only a secondary consideration. For the most part,
when a banker makes a term loan, he or she is looking at the cash
flow of the enterprise and trying to determine whether it is
sufficient to service the debt and whether it can be sustained for
the term of the loan.

Asset-based lenders, on the other hand, have a dual focus. They,
too, look at cash flow, but they also look at two asset
classes--accounts receivable and inventory--in terms of their
ability to be liquidated to pay off the loan if the cash flow goes
south. Short-term asset-based loans generally get paid off as
accounts receivable and inventory liquidate.

In growing businesses, however, more accounts receivable and
inventory are being generated all the time. As a result of this
cycle, an asset-based loan has a revolving quality to it. This can
be a good thing because it gives a company time to catch its
breath. But it can also work to a company's disadvantage. If an
asset-based loan isn't renewed by the lender, for example, the
company may be forced to pay the borrowed money back before
it's prepared to do so.

People Who Need People

An asset-based lender's emphasis on assets rather than cash
flow makes a significant impact on the relationship between lender
and borrower, according to Barnett.

The asset-based lender is taking a so-called security position
in the underlying assets and views liquidation of them as a viable
means of recovering the loan principal. In addition, because the
asset-based lender is lending against assets, which can rapidly
fluctuate in value, it monitors these assets more intensively.
"It's not uncommon for asset-based lenders to look at a
company's inventory or accounts receivable once a month,
sometimes even more frequently," says Barnett. Conventional
lenders making term loans, on the other hand, might review
financial data just once a quarter and never look at inventory
after the initial loan is made.

Adding Up Your Assets

Your borrowing capacity for an asset-based loan rests on what
your assets will support and the maximum line a lender will grant
you. Barnett says most asset-based lenders will lend 80 percent of
"eligible" receivables and 50 percent of
"eligible" inventory. So what do we mean by eligible?

Basically, just because you have an asset on the books
doesn't necessarily mean a lender will advance you funds
against it. "Asset-based lenders deduct ineligible receivables
such as those from mom-and-pop shops, those from customers who have
had a bad debt on prior receivables, ones that are more than 90
days old or, perhaps, receivables due from customers
overseas," says Barnett.

So on the receivables side, the equation looks like this:

The same concept applies to inventory. That is, the inventory on
hand needs to be adjusted by the lender. Specifically, ineligible
components must be removed to estimate the eligible portion.
Ineligible inventory might include items that are obsolete, certain
exotic goods that would be difficult to liquidate, perishables that
may spoil before they can be liquidated or materials that are
damaged. The inventory equation is as follows:

Barnett says adding the two sums together and subtracting any
outstanding debt gives you the amount you can borrow, as long as it
doesn't exceed the total line available to your company, which
is spelled out in your agreement with the lender.

Why does inventory get such a low advance rate, just 50 percent
of eligible inventory, while accounts receivable gets 80 percent of
the eligible amount? According to Timothy Gannon, senior vice
president of the asset-based group at Sterling National Bank, a
publicly held New York City bank that specializes in small- and
middle-market companies, "Accounts receivable are
self-liquidating, while inventory is not. If a lender needs to
liquidate to recover the loan, it will have to take possession of
the inventory and sell it, which can be difficult, time consuming
and expensive." By contrast, he says, the majority of a
company's accounts receivable will, over time (hopefully in 30
days), turn themselves into cash through payments from
customers.

Anatomy of a Loan

Here's how a typical asset-based loan made against a
company's receivables might work.

Step 1. The company sells its product or service to
customers. Unless it's a cash-based business or a business
where customers pay for all their purchases by credit card, a
receivable is created. The receivable, really a debt owed to the
company, is usually repaid in 10, 15, 30 or 45 days.

Step 2. The lender makes a loan to the company based
on the value of the receivables, typically advancing 80 percent of
eligible receivables. The moment the funds are advanced, the
company starts paying interest on the loan.

Step 3. Customers are instructed to send their
payments directly to the finance company.

Step 4. The lender remits to the company the invoice
payments, less the principal on loans it has already advanced, less
interest.

Step three can make borrowers queasy--and for good reason. After
all, in any business, cash flow equals life, and placing your
lifeblood under the control of a third party can bring risks. For
instance, suppose a borrower has a large outstanding balance
that's continuously revolving. Further suppose that an entire
group of the borrower's customers had sold products to a region
of the world which experienced a financial meltdown. The lender,
who monitors the assets very closely and begins to see the length
of these customers' receivables expanding, may take a
"reserve" to protect itself. Instead of remitting
customer payments to the company, the lender holds some of them as
a reserve against future loan losses. Suddenly, the company
doesn't have funds it may have been counting on.

Requirements and Scenarios

Sterling's Gannon says that to successfully negotiate an
asset-based deal, borrowers must come to the table with financial
information that paints a positive picture and is detailed and
accurate. Among the requirements he cites:

The business must have a reasonable net worth and long-term
viability.

Financial statements must be reviewed by a certified public
accountant whom the lender deems acceptable.

Borrowers must submit one year's worth of monthly
projections.

The business's principals must guarantee the loan and
support the guarantee with personal financial statements.

Keyman life insurance may be required.

Gannon says even if you qualify for an asset-based loan, it
might not be the best way to go. "Asset-based loans are more
expensive than bank lines of credit and often much more intrusive
on the borrower," he warns.

For instance, he says, if you have a good guarantee, are
profitable and need to borrow, say, $500,000 for 60 days twice a
year, you should go to a commercial bank. "That's the
cheapest, easiest way to go," Gannon says.

Similarly, if you have a good guarantee and need a line of
credit to support inventory and receivables that can be paid back
within one year, there's a good chance a bank will take a
security interest in your inventory and receivables and offer a
line of credit or a revolving line of credit. "This also will
be cheaper than a traditional asset-based loan," says
Gannon.

But, he says, "If your guarantee is not that strong,
you're not that profitable, your business is undercapitalized,
you need working capital, and there's no way you can pay off a
line of credit for perhaps two or three years, you present a
problem for most banks even if your business is a good one."
In these instances, he says, a bank will often refer you to a
finance company offering asset-based loans--this may be your only
salvation.

Next Step

You can start your search for an asset-based lender at the
Commercial Finance Association's Web site, http://www.cfa.com Using the site's
search engine, enter the amount and type of capital you're
looking for. You'll be given contact information for commercial
finance companies matching your criteria.